The IRS issued a new Audit Technique Guide entitled Real Property Foreclosure and Cancellation of Debt Audit Technique Guide that is meant to provide guidance to agents who encounter issues involving foreclosures and/or cancellation of debt. However, as is true of many other such guides, the guide also provides a reasonably useful primer on the tax treatment in this area and contains some hints about the National Office of the IRS’s thinking on certain issues that may not be clear.
The IRS guide, which runs for 70 pages in PDF form, is organized into 11 chapters on a topical basis. Those chapters are:
- Type of Debt
- Income from Discharge of Indebtedness
- Tax Attribute Reduction
- Rental Real Estate Property
- Form 1099-A and Form 1099-C
- Community and Common Law Property
- Audit Strategies
- Rehabilitation Credit and IRC §469
- Low Income Housing Credit
Specific items of interest include discussions related to recourse vs. nonrecourse debts. Since some state laws provide rules (often referred to as “anti-deficiency” provisions) that apply in specific cases to real property mortgages, many advisers find it difficult at times to determine if a debt is or is not recourse for federal tax purposes.
As the guide notes in its section on “type of debt” the determination of the type of debt can have a major impact on the tax result in a specific situation. The guide provides an example of the differences and their potential impact reproduced below:
Analysis of Disposition of Property Secured by Nonrecourse or Recourse Debt:
The primary difference between nonrecourse and recourse debt is the timing and amount of any potential taxable income from the disposition and cancellation of debt income demonstrated in the following table. For this analysis, the outstanding loan balance is $300,000, the fair market value of the property is $265,000, and the adjusted basis is $280,000. The cancellation of debt income is $35,000 ($300,000 outstanding loan balance minus $265,000)
The nonrecourse note results in a gain of $20,000 ($300,000 amount realized minus $280,000 adjusted basis). Whereas, the recourse note results in a disposition loss of $15,000 ($265,000 amount realized minus $280,000 adjusted basis) plus $35,000 of cancellation of debt income resulting in a net gain of $20,000. The overall tax consequence for both notes is a gain of $20,000. However, the $35,000 cancellation of debt income can be deferred through the reduction of tax attributes if the taxpayer qualifies to exclude the cancellation of debt income under IRC §108.
The guide’s definitions for recourse and nonrecourse debts (reproduced below) are useful for making this distinction. Specifically advisers should note the second and third sentence in the definition of “recourse debt” provided below:
Nonrecourse Debt – The borrower is not personally liable and repossession of the mortgaged property, for example, will generally satisfy the outstanding debt.
Recourse Debt – The borrower is personally liable for the loan. Meaning, the lender can obtain a deficiency judgment against the borrower in court for any outstanding balance that is not satisfied through a foreclosure sale. State law of where the property is located governs whether the lender is able to obtain a deficiency judgment. [Emphasis added]
The IRS also makes clear to agents that the fact a Form 1099C may not have been issued is not determinative of whether cancellation of debt has taken place, emphasizing a collection activity test.
As the guide provides:
Sometimes a lender may erroneously fail to issue the taxpayer a Form 1099-C. Facts and circumstances will dictate when or if any outstanding debt has been discharged, absent the issuance of a Form 1099-C. Under IRC §7491(a)(1), under certain circumstances, in any court proceeding, the burden shifts to the IRS to prove that the taxpayer received cancellation of indebtedness income if the taxpayer provides creditable evidence with respect to any factual issue relevant to ascertaining the income tax liability of the taxpayer. See discussion later on Form 1099-A and Form 1099-C.
Consideration of whether the lender has pursued collection activity and the state where the property is located are two primary factors. Each state has its own foreclosure legal laws and time frames that a lender must pursue collection activities. Absent a Form 1099-C, it is reasonable to conclude that the taxpayer was forgiven the outstanding balance if the lender has not pursued collection activity in accordance with the state law of the location of the property. For example, if a foreclosure is completed by non-judicial means in some states, the lender is precluded from pursuing a deficiency judgment for the outstanding balance.
The guide also warns agents about the complexities introduced by various state anti-deficiency laws in this area. It notes:
Some states, shown in Table 1, Anti-Deficiency/Nonrecourse States, have anti-deficiency laws which prohibit a lender from pursuing a deficiency judgment against the borrower under certain circumstances. Although, these states are identified as Anti-Deficiency states, it is important to note that each of these states has its own rules and the anti-deficiency rules are not applied in the same manner. It is important to understand the state law where the property is located as it could make a difference in the amount of income includable in taxable income or excludable from taxable income.
It is advised to seek assistance from local Counsel for specific state questions regarding foreclosures. Refer to the Local Law Section in IRM 5.17, Legal Reference Guide for Revenue Officers for more information.
While the advice to seek information from local counsel is directed to agents, the same advice should be followed by tax advisers who are not themselves attorneys. The issue in question is one of local law and only after that is understood can the tax law then be applied to the situation.
This guide likely appeared because agents are running into this issue quite often and, as many cases during the real estate crises showed, quite often the Form 1099C issuance by lenders has not followed the provisions outlined in the regulations for issuing such forms, resulting in a number of cases where the Tax Court found that cancellation of debt took place, it did so in a year other than that in which the Form 1099C was issued.
The guide provides a useful resource to guide advisers through the basics of this rather messy area of tax law. It also gives advisers some idea about the approach agents are going to be instructed to take if an examination takes place in a year where there may or may not have been a cancellation of debt event.